Law Firm Valuation Part I - Altman Weil

Law Firm Valuation Part I

By William F. Brennan

William F. Brennan

This article focuses on the valuation of US law firms and covers the legal marketplace, law firm financial records and valuation methodologies. It is not applicable to law firms outside the U.S. where different market and regulatory conditions may exist. Parts II and III will run in the next two issues of RTLM.

t he valuation of a law firm is affected by many factors, especially the purpose of the valuation. Law firms may need to be valued for a variety of reasons, including:

? Estate planning

? Marital dissolution

? Insurance coverage

? Capital buy-in of a new owner

? Capital buy-out of a withdrawing owner

? Dissolution of a firm

? Merger or acquisition

The exercise of valuing a law firm is more art than science, and a universally accepted approach to law firm valuation does not exist. The appropriate valuation methodology to use depends upon the objective of the valuation. In certain situations, the valuation methodology required is stipulated by the Internal Revenue Service (IRS) or the courts based on case law precedents, especially in divorce cases. Valuation formulas vary by jurisdiction and some jurisdictions have adopted radically different positions, especially relating to the treatment of goodwill. Valuation methods stipulated by the courts, the IRS or other regulatory bodies should be understood as possible precedents for valuation methodology elsewhere. Appearing before those regulatory bodies and applying a valuation method that deviates from approved methods will require that you not only successfully argue the merits of your alternative method, but also successfully argue against the previously approved method.

The discussion in this article of law firm operations generally and valuation methodologies

specifically is based upon experience managing law firms as a chief financial officer (CFO) for a decade, plus 18 years experience consulting exclusively to law firms on management issues including financial management, profitability enhancement, strategic planning and mergers and acquisitions. Accordingly, this analysis discusses the valuation of law firms primarily from a business perspective rather than from a valuation expert's perspective.

The Legal Marketplace The legal marketplace in the United States generated approximately $200 billion of gross domestic product in 2008 according to the Bureau of Economic Analysis (. industry/gdpbyind_data.htm). The vast size of the legal market makes references to the legal profession as a single entity overly simplistic. That is, the 1,000-lawyer law firm is not simply 100 times larger then the 10-lawyer law firm. They are vastly different organizations with different clients, geographic reach, service offerings and valuation challenges. This distinction is made because it does not seem to receive the attention it deserves in other discussions of law firm valuations.

The legal profession must be stratified into segments that share some commonality for any valuation analysis to be meaningful. It can be segmented by geographic reach or by size of law firm, and possibly by practice specialties. This last attribute, practice specialty, is complicated by the lack of a universal taxonomy for describing practice specialties. Two firms may practice in exactly the same area, but name their practices differently. Even the appropriate size categories are not without some controversy. Altman Weil has surveyed the legal

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"The exercise of valuing a law firm is more art than science..."

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Law Firm Valuation ... continued from page 3

profession for over 30 years and yet there is still no general consensus within the industry regarding the definition of a large, medium or small firm. The answer to that question often depends on the specific geographic market in question, since a 100-lawyer firm in New York City may be considered small whereas the same size firm in Albany would be large. For purposes of this topic, law firms in the following size groupings share considerable characteristics and exhibit significant differences between firms in different categories:

Large = 174 or more lawyers Medium = 31 to 173 lawyers Small = 11 to 30 lawyers Tiny = 10 or fewer lawyers

For our purposes, large firms shall be defined as the 250 largest US law firms (as identified in the "NLJ 250" list published annually by the National Law Journal). In 2008 there were 27 law firms with over 1,000 lawyers according to the NLJ 250.1 The average number of lawyers in the NLJ 250 law firms in 2008 was 534, the smallest was 174. The aggregate revenue reported by the AmLaw 200 law firms for 2008 was $84,335,500,000 with average revenue for each of the 200 law firms of over $420 million.2

These are large businesses with very experienced professional CFOs, CMOs, CIOs, and COOs. They have sophisticated business processes, and organize themselves around practice specialties, clients, and locations. There is a growing use of line of business management, or, in professional service environments, probably better stated as practice leadership. They have well-defined performance standards, business models and strategies. Most of these firms have multiple offices that often span nations and continents.

Audited financial statements and sophisticated business records and information are the norm.

In contrast are the tiny law firms. Here a designated Managing Partner

Report, published by the American Bar Foundation. In 2000, there were 909,019 total lawyers in the US. Seventy-four percent, or 672,901 lawyers, were in private practice.

"... there is still no general consensus within the industry regarding the definition of a large, medium or

small firm."

may exist for administrative matters. Each practice, however, often is managed by each individual partner with little if any supervision. These firms rarely have an internal CFO and instead tend to rely more on their outside accounting firm for financial advice. These firms are less likely to use the level of sophisticated technology applications that are commonly found in large firms. Generally they will have a computer network that facilitates sharing of documents and peripheral computer equipment.

Most tiny firms will have a computerized time and billing application, but some do not. Obtaining documentation of the financial condition of such firms is often more difficult than with larger law firms. Frequently the only historical financial records that exist are tax returns and, absent a computer time and billing system, calendar notations of work performed by the lawyers for specific clients. It is not uncommon for these firms to use fringe benefits generously as additional forms of compensation, which presents a separate set of issues for determining an accurate valuation.

To give further perspective to the demographics of the legal marketplace, let's look at the distribution of US lawyers by size of firm. The following information is consolidated from The 2000 Lawyer Statistical

Solos, i.e., lawyers in practice alone, comprised 48% of the lawyers in private practice.

The following table indicates the number of lawyers in private practice who worked in multi-lawyer settings by the size of their law firms:

2-10 lawyers

144,784

11-100 lawyers

107,323

101 or more lawyers 95,892

Therefore, when taken in conjunction with solo practitioners, nearly 70% of the lawyers in private practice were practicing law in firms of 10 or fewer lawyers in 2000.

Law firms offer scores of different legal services to clients. Some common practice areas are corporate, commercial litigation, real estate, trusts & estates, school law, intellectual property (IP), taxation, divorce, personal injury and immigration. Firms that offer a wide range of practice specialties, including most largeand medium-size firms, are called general practice firms. Law firms that concentrate their practice in a particular area of law have many internal similarities. For example, firms that limit their practice to trusts and estates are usually similar to each other in terms of work effort, culture, profitability and organization and are very different from firms that specialize in other areas, such as personal

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injury firms or intellectual property boutiques.

A relatively simple way to categorize law firms in terms of their practice is by their clientele. Firms that primarily serve individuals and families may be called "retail" law firms while others that primarily serve corporations may be called "corporate" law firms. Corporate law firms tend to be larger, rely more on professional managers, use sophisticated technology more extensively, have more stringent controls and appear to be more business-like than retail law firms. The latter are often smaller, less wedded to policies and procedures, more family-oriented, and less structured in their operations. Large- and medium-sized law firms primarily serve corporate clients while most small and tiny law firms primarily serve retail clients. Obviously, in such a vast marketplace there are many exceptions to those general rules.

For a comprehensive listing of the various types of law offered by law firms refer to one of the following websites:

?

?

?

Understanding the types of law offered by the particular law firm being valued is important since it can provide meaningful information about the law firm, its lawyers, clients, operations, and possibly even the firm's culture. This background information is very helpful in gaining an understanding of the subject firm, especially in conjunction with the firm's size and geographic location. It allows for meaningful benchmark comparisons to be made to comparable law firms, which can indicate if the subject firm is exceptionally profitable or unprofitable compared to its peers, if income appears to be understated (for forensic engagements), if

expenses are unusually high, or if there are other unusual characteristics of the firm being valued. It can also highlight unusual relationships between revenues and particular expenses, such as occupancy expense, client entertainment expense, retirement expense, etc. This background information provides a framework for selecting the appropriate valuation methodology to use for a particular engagement.

1 2008 NLJ 250, ALM Properties, Inc. 2 2009 AmLaw 200; Incisive US

Properties, LLC

William F. Brennan is a principal of Altman Weil, Inc., working out of the firm's offices in Newtown Square, Pennsylvania. He can be reached at (610) 886-2000 or bbrennan@.

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Report to Legal Management

April 2010 9

Law Firm Valuation Part II

By William F. Brennan

William F. Brennan

This article focuses on the valuation of U.S. law firms and covers the legal marketplace, law firm financial records and valuation methodologies. It is not applicable to law firms outside the U.S. where different market and regulatory conditions may exist. Part I ran in last month's issue of RTLM; Part III will appear in next month's issue.

Law Firm Financial Records As with all businesses, the financial records that form the foundation of any valuation engagement are the balance sheet and income statement. Most law firms maintain their books and records, as well as their tax returns, on the modified cash basis of accounting. Under this method, revenue is recognized when fees are collected rather than when they are billed or earned (e.g., when the professional services are actually performed). Expenses are recognized when they are paid rather than when the expense is incurred. Fixed assets are capitalized rather than expensed and depreciation, a noncash expense, is also recorded. At year-end, pension obligations are often accrued, even though they are paid in the following year. That is why this method is a "modified cash method," but for simplicity it is commonly called the "cash method." The accrual basis of accounting recognizes revenue when the professional services are earned, which is when they are performed under an agreement with a client. The modified accrual basis recognizes revenues when the fees are billed to a client. In the U.S., law firms generally file tax returns on the cash basis and accordingly report financial results in the same manner. Large law firms are more likely to have audited financial statements prepared according to GAAP.

The difference between the various accounting methods used by law firms can be illustrated by Figure 1 on page 4, a graphical depiction of the flow of financial activity in a law firm. It is analogous to the flow of water through a series of three buckets, with the first bucket representing unbilled time,

or work-in-process (WIP); the second bucket representing accounts receivable; and the third bucket representing cash.

Law firm timekeepers, including lawyers and paralegals, record their time which is entered into the firm's time and billing system. Billable time is valued at the appropriate billing rate. This activity is depicted in Figure 1 by the first arrow above, and it is usually called "time value added" or "recorded time value." Under the accrual basis of accounting, revenue would be recognized when the professional services are actually performed, which is depicted by the first arrow. It is typically about four or five months after the legal services are performed that fees are collected from clients.

This billable, recorded time is added to any prior balance of unbilled time, or work-inprocess (WIP) to yield an updated balance of time value. The first bucket represents WIP. A subsidiary WIP ledger indicating the net balance for each client should support the aggregate amount of WIP reported in the firm's general ledger and most computerized time and billing systems verify the integrity of that relationship each month. The specific accounting entry to record the transaction (as deferred revenue or as revenue) will depend upon whether the firm is using the cash, accrual or modified accrual method of accounting. Typically each month the billing lawyer for each client will make a determination of what amount can and should be billed to the client. Generally two to three months of unbilled time value will reside in WIP at the end of each month.

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The amount that can be billed is converted from WIP to accounts receivable and any variance between the two amounts is written down or up within the computer system. Reverting to the flow of water analogy, billings are reflected by the second (black) arrow and the portion that does not make it to the second bucket, the spillage, or loss, is represented by the small arrow labeled "write-downs." The firm should have a subsidiary ledger of all accounts receivable balances that supports the aggregate amount of accounts receivable reported in the firm's general ledger.

Subsequently clients remit their payments to the law firm and the receipts are posted to the client accounts, resulting in the accounts receivable being converted to cash receipts. Any variance may need to be recorded as a write-off in the computer system. Using the flow of water analogy, receipts are represented by the third arrow and the write-offs of accounts receivable are represented by the second arrow labeled "writeoffs." This financial information should be available from almost all law firms except perhaps tiny firms. It is important to analyze trends in these financial statistics to identify

aberrations, such as a significant reduction in the inventory of WIP and accounts receivable, which could indicate an impending cash flow shortage and a related reduction in the firm's value.

Law firms using the cash basis of accounting record revenue when the cash receipts are collected by the firm (the first arrow). These firms would not generally record accounts receivable or unbilled time (WIP) on their balance sheet (although unrecorded subsidiary ledgers usually exist, even if only within the firm's time and billing system). An accrual basis accounting system would recognize revenue in its income statement when the billable time was recorded (the third arrow). Such firms would record both unbilled time (WIP) and accounts receivable balances on their balance sheet. A law firm using a modified accrual basis of accounting would record revenue in its income statement when the fees are billed to the client (the second arrow). Such firms would likely record accounts receivable on its balance sheet but not unbilled time (WIP).

Figure 1 becomes more meaningful by adding benchmarks to it to show the relative magnitude of values reported for each particular financial statistic. Using data provided

FIGURE 1

Financial Benchmarks Per Lawyer

Recorded Time = Billable Hours * Rates (1,716 Prt / 1,786 Assoc) * ($329 Prt / $221 Assoc)

Billings = $394,000 per lawyer

Gross Receipts = $431,000 per lawyer

WIP

Acc. Rec. 2.5 Months

$85,000 per lawyer

Writ$e5-d0o,0w0n0s 2.1 Months

$67,000

per lawyer

Wr$it1e3-o,0ff0s0

Source: 2008 Survey of Law Firm Economics Incisive Media

Cash

Overhead = $170,000

by the 2008 Survey of Law Firm Economics published by Incisive Legal Intelligence Surveys (formerly Altman Weil Publications, Inc.), a division of Incisive Media, LLC, Figure 2 on page 5 provides an indication of the magnitude of each statistic for the average law firm participating in the survey.

Each of the statistics in Figure 2 varies for firms of different sizes, practice specialties and geographic location. Unless the law firm that is being valued is truly "an average" law firm, the above benchmark statistics may not be appropriate for comparison to a particular law firm. For example, the average gross receipts for the 200 highest grossing U.S. law firms (the "AmLaw 200" list published annually by The American Lawyer) was $728,500 in 2008.1 This is 69% greater than the average reported above. It is important to compare the financial performance of a particular law firm being valued to its peer firms to ensure a valid comparison. Benchmarking can aid in the identification of significant variances from the average of comparable firms. Clearly this information could be of substantial assistance in identifying unreported income in a forensic analysis, as well as providing a general indication of the relative profitability of a specific firm compared to its peers, which might be indicative of any goodwill value. It can also indicate the normal relationship between revenue and specific expenses, such as occupancy or entertainment expense. Benchmarking surveys for law firm financial statistics are available from multiple sources.2 Other law firm financial surveys may also be available. Many of these surveys are relatively inexpensive and may aid in completing a law firm valuation analysis.

Valuation Methodologies There are many different methods for

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